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Important judgment for taxpayers regarding trading stock valuation

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In C:SARS v Volkswagen SA (Pty) Ltd(1) the Supreme Court of Appeal dealt with important principles in the Income Tax Act (58/1962) – specifically Section 22 of the act, which deals with the amounts to be taken into account in respect of trading stock. The judgment will likely have far-reaching consequences for many taxpayers and this article provides a brief analysis of the key issues and principles underpinning the judgment.

In Volkswagen the task before the court was to determine whether the net realisable value (NRV) of Volkswagen South Africa's (the taxpayer) trading stock, calculated in accordance with International Accounting Standard 2 (IAS2) of the International Financial Reporting Standards (IFRS), may and should (where the NRV is lower than the cost price of such trading stock) be accepted as representing the value of the trading stock held and not disposed of at the end of the respective assessment years for purposes of Section 22(1)(a) of the act.

Issue

In its simplest form, Section 22 of the act is a timing provision which ensures that the cost of trading stock owed by a taxpayer matches the income earned in respect of that trading stock sold or otherwise disposed of.

In this instance, the Supreme Court of Appeal considered Section 22(1)(a) of the act, which sets out the general rule pertaining to closing stock held and not disposed of which must be included in the taxpayer's income at the end of the assessment year. The closing stock to be included in the taxpayer's income is the cost price of the trading stock, unless the commissioner finds that the value of such trading stock has been diminished by reason of:

damage;

deterioration;

a change of fashion; or

a decrease in market value.

In Volkswagen, the taxpayer contended that it had been entitled to reflect the value of its trading stock at less than cost, as per Section 22(1)(a) of the act. The contention made on behalf of the taxpayer was that it should be entitled to do this based on the NRV of its trading stock, which had been calculated in accordance with IAS2, as the NRV reflected that the value of its trading stock had been diminished.

Importantly, for purposes which will become more apparent later, the taxpayer's trading stock constituted multiple unsold vehicles including trucks, buses and passenger vehicles. Further, given that 'NRV' is defined as the estimated selling price of inventory in the ordinary course of business, subtracted by the estimated costs of completion and the estimated costs necessary to make the sale, the individual categories of cost taken into account in determining the NRV of its trading stock were described generally as:

rework or refurbishment costs;

outbound logistics;

marine insurance;

sales incentives;

distribution fees;

warranty costs;

costs relating to the Audi Freeway Plan and the Volkswagen AutoMotion Plan; and

roadside assistance costs.

Supreme Court of Appeal's interpretation

The Supreme Court of Appeal commenced with its interpretation of the relevant provisions of Section 22 of the act and provided examples of what is contemplated in Section 22(1)(a) at paragraphs 14 and 15, as follows:

Four circumstances namely, damage, deterioration, change of fashion or decrease in market value, are specified as causing a diminution in the value of trading stock. All of those can be illustrated quite simply. Goods may be damaged in transit and as a result can only be sold at less than cost. Their condition may deteriorate whilst in transit or in storage, as with a cargo of first grade rice undergoing heating at sea, so that it has to be downgraded to second or third grade and is only saleable at less than cost. Fashionable clothing tends to be seasonal and, if not sold before the end of the season, retailers may need to dispose of unsold surplus stock at discounted prices below cost. A decrease in the value of trading stock may arise where stock has been acquired at a particular price and the supplier subsequently reduces the price. For example, a retailer might acquire mobile phones for R400 from the manufacturer. If the manufacturer cuts its price to retailers to R300, in order to get rid of stock before introducing a new model phone, the value of the stock acquired at R400 has diminished.

The section contemplates the possibility of other reasons for the value's diminution apart from the four that had been specified. For that reason, this section empowers the commissioner to make a just and reasonable allowance to accommodate a diminution in the value of trading stock for any other reason that it finds satisfactory.

Justice of Appeal Wallis held that the wording of Section 22 requires an examination of the assessment year under consideration, given that the language is couched in the past tense. Thus, the section is not strictly concerned with what may occur in future, albeit that there is nevertheless an element of futurity.

According to Wallis, the correct position was that the commissioner can grant a just and reasonable allowance in respect of a diminution in the value of trading stock under Section 22(1)(a) only in two circumstances:

where some event occurred in the relevant tax year which caused the value of the trading stock to diminish; and

where it is known with reasonable certainty that an event will occur in the following tax year which will cause the value of the trading stock to diminish.

In relation to the second circumstance, Wallis used an example relating to simple supply and demand microeconomics – namely, where a taxpayer knows that an excess supply has built up in the market for a perishable commodity and that oversupply will ensure a marked, certain and unavoidable decline in the price of that commodity in the following year.

Another important aspect of Wallis' judgment was that he found the cost price of the goods – and not the actual or anticipated market value on disposal – should be the benchmark, against which any diminution in value should be allowed. Wallis concluded that known events during the year in question (or events that will occur with reasonable certainty in the following year) which have led to the cost price of the goods ceasing to be the proper measure of their value must be present.

Having established the court's views regarding the interpretation and application of Section 22(1)(a) of the act in general terms, Wallis proceeded to consider the taxpayer's arguments and submissions against this background, with specific reference to the taxpayer's use of the NRV as calculated in accordance with IAS2 to value its trading stock at year end.

Discussion of issues and judgment

Having considered and discussed the relevant aspects of the NRV as calculated in accordance with IAS2, and with specific reference to the taxpayer's submissions, Wallis held at paragraph 43 as follows:

There is obvious scope for an overlap between the provisions of s22(1)(a) and those of IAS 2. The former refers to a diminution of value of trading stock caused by damage, deterioration, change of fashion, or decrease in market value. Clause 28 of IAS 2, quoted above in para [35], records that the cost of inventories may not be recoverable if they have been damaged or have become obsolete in whole or part. To that extent the two correspond. But the other elements to which IAS 2 refers do not relate to the same matters as s22(1)(a). They are concerned with future matters such as changes in likely selling prices, or increases in the estimated costs of completion or the estimated costs of making sales.

Wallis raised several practical difficulties in accepting the taxpayer's method, including that writing down the value of part of the stock to NRV ignores the fact that the NRV of the remaining stock was higher than the cost price and that it would leave the commissioner with little scope for assessing the legitimacy of a calculation relating in its entirety to the taxpayer's future trading circumstances.

In addition to the practical difficulties discussed, in upholding the appeal and finding in favour of the commissioner, Wallis held that the use of NRV in this context was inconsistent with two basic principles of the act:

NRV is patently forward looking, whereas the concept of taxation is backward looking and therefore incompatible.

By using NRV in this context, any expenses incurred in a future assessment year in respect of the income earned in that succeeding year becomes deductible prematurely in a prior year (ie, timing mismatch).

Observations

This judgment will undoubtedly have a far-reaching and profound impact on how taxpayers and the South African Revenue Service consider, interpret and apply Section 22(1)(a) of the act. However, the key question is the extent to which the judgment can be applied in matters of this nature. Notably, the Supreme Court of Appeal was presented with a specific set of facts which may ultimately result in the judgment having, to some extent, limited application.

For instance, 'trading stock' as defined in Section 1 of the act contemplates three separate categories of trading stock. In Volkswagen, the Supreme Court of Appeal was tasked with broadly considering the first two categories of trading stock, namely anything:

that is produced, manufactured or acquired for the purposes of sale or exchange; or

the proceeds on disposal of which form part of the taxpayer's gross income.

In short, these categories relate to stock which is ultimately acquired or produced for sale or disposal thereof.

However, the Supreme Court of Appeal was not tasked with considering the application of Section 22(1)(a) of the act within the context of the altogether different third category of trading stock (namely consumable stores) and spare parts acquired by a taxpayer to be used or consumed in the course of the taxpayer's trade. This category of trading stock is not within the realm of the usual trading stock contemplated and is used in a taxpayer's production process as opposed to being used for resale purposes. Thus, arguably, Volkswagen should be applied with a measure of caution to the calculation of the diminution in value of this category of trading stock, given its distinct features.

Another important aspect from the judgment is the general discussion of accounting principles and their application to South African tax law concepts. Since time immemorial, there has been robust discussion regarding the use and application of accounting principles in tax law. While Wallis clarified that the accounting principles must be applied to interpretational difficulties in tax law with caution, on careful reading of the judgment, Wallis arguably stopped short of completely discarding the value and benefit of accounting principles in ascertaining the reasonability of tax positions taken by taxpayers in specific circumstances.

The application, interpretation and effects of this judgment will certainly be interesting to observe in future.

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